1 Monopolistic and Oligopoly Chapter 10 © 2006 Thomson/South-Western

2 Monopolistic Competition  Many producers offer products that are either close substitutes but are not viewed as identical  Each supplier has some power over the price it charges : price makers  Low barriers to entry: firms in the long run can enter or leave the market with ease  Act independently of each other  Differentiate their products

3 Exhibit 1a: Maximizing Short-Run Profit  The monopolistically competitive firm produces the level of output at which marginal revenue equals marginal cost (point e) and charges the price indicated by point b on the downward-sloping demand curve.  In panel (a), the firm produces q units, sells them at price p, and earns a short-run economic profit equal to (p – c) multiplied by q, shown by the blue rectangle.

4 Exhibit 1b: Minimizing Short-Run Loss  In panel (b), the average total cost exceeds the price at the output where marginal revenue equals marginal cost.  Thus, the firm suffers a short-run loss equal to (c – p) multiplied by q, shown by the pink rectangle.

5 Zero Economic Profit in the Long Run  Low barriers to entry in monopolistic competition: short-run economic profit will attract new entrants in the long run  With losses some competitors will leave the industry  Their customers will switch to the remaining firms, increasing the demand for each remaining firm’s demand curve and making it less elastic

6 Exhibit 2: Long-run Equilibrium p 0 q MC ATC MR D a b Quantity per period  In the long run, entry and exit will shift each firm’s demand curve until economic profit disappears and price equals ATC  Long-run outcome occurs where the MR curve intersects the MC curve at point a, where the ATC curve is tangent to the demand curve at point b and there is no economic profit  In the case of short-run losses, some firms will leave the industry and the demand curve shifts to the right, becoming less elastic until the loss disappears and the remaining firms earn a normal profit Dollars per unit

7 Exhibit 3: Perfect Competition versus Monopolistic Competition  Point of tangency between d, MC and ATC in perfect competition means firm is producing at lowest possible average cost in the long run  In monopolistic competition, the price and average cost exceed those in pure competition – there is excess capacity

8 Comparison  Firms in perfect competition are not producing at minimum average cost and are said to have excess capacity, because production falls short of the quantity that would achieve the lowest average cost.  Excess capacity means that each producer could easily serve more customers and in the process would lower average cost.  The marginal value of increased output would exceed its marginal cost, so greater output would increase social welfare.

9 Comparison  Some argue that monopolistic competition results in too many suppliers and in product differentiation that is often artificial  Counterargument is that consumers are willing to pay a higher price for greater selection

10 Oligopoly  Market structure that is dominated by just a few firms  Each must consider the effect of its own actions on competitors’ behavior  the firms in an oligopoly are interdependent

11 Varieties of Oligopoly  Homogeneous or differentiated products  Interdependence: the behavior of any particular firm is difficult to analyze  Domination by a few firms can often be traced to some form of barrier to entry

12 Exhibit 4: Economies of Scale as a Barrier to Entry D o l l a r s p e r u n i t c a c b Autos per year S b a Long-run average cost 0  If a new entrant sells only S cars, the average cost per unit, c a, exceeds the average cost, c b, of a manufacturer that sells enough cars to reach the minimum efficiency scale, M.  If autos sell for a price less than c a, a potential entrant can expect to lose money. M

13 High Costs of Entry  Total investment needed to reach the minimum size  Advertising a new product enough to compete with established brands  High start-up costs and presence of established brand names: the fortunes of a new product are very uncertain

14 Models of Oligopolies  Interdependence: no one model or approach explains the outcomes  At one extreme, the firms in the industry may try to coordinate their behavior so they act collectively as a single monopolist, forming a cartel  At the other extreme, they may compete so fiercely that price wars erupt

15 Collusion  Collusion: an agreement among firms in the industry to divide the market and fix the price  Cartel: a group of firms that agree to collude so they can act as a monopolist and earn monopoly profits  Colluding firms usually reduce output, increase price, and block the entry of new firms

16 Exhibit 5: Cartel as a Monopolist  D is the market demand curve, MR the associated marginal revenue curve, and MC the horizontal sum of the marginal cost curves of cartel members (assuming all firms in the market join the cartel).  Cartel profits are maximized when the industry produces quantity Q and charges price p.

17 Differences in Cost  The greater the differences in average costs across firms, the greater will be the differences in economic profits among firms  If cartel members try to equalize each firm’s total profit, a high-cost firm would need to sell more than a low-cost firm  This allocation scheme violates the cartel’s profit-maximizing condition of finding the output for each firm that results in identical marginal costs across firms

18 Number of Firms in the Cartel  The more firms in the industry, the more difficult it is to negotiate an acceptable allocation of output among them  Consensus becomes harder to achieve as the number of firms grows

19 New Entry Into the Industry  If a cartel cannot block the entry of new firms into the industry, new entry will eventually force prices down, squeezing economic profit and undermining the cartel  The profit of the cartel attracts entry, entry increases market supply and market price is forced down

20 Cheating  Perhaps the biggest obstacle to keeping the cartel running smoothly is the powerful temptation to cheat on the agreement  By offering a price slightly below the established price, a firm can usually increase its sales and economic profit  Because oligopolists usually operate with excess capacity, some cheat on the established price

21 Price Leadership  An informal, or tacit, type of collusion occurs in industries that contain price leaders who set the price for the rest of the industry  A dominant firm or a few firms establish the market price, and other firms in the industry follow that lead, thereby avoiding price competition  Price leader also initiates price changes

22 Price Leadership  Violates U.S. antitrust laws  The greater the product differentiation among sellers, the less effective price leadership will be as a means of collusion  There is no guarantee that other firms will follow the leader  Some firms will try to cheat on the agreement by cutting price to increase sales and profits  Unless there are barriers to entry, a profitable price will attract entrants

23 Game Theory  Game theory examines oligopolistic behavior as a series of strategic moves and countermoves among rival firms  It analyzes the behavior of decision-makers, or players, whose choices affect one another  Provides a general approach that allows us to focus on each player’s incentives to cooperate or not

24 Payoff Matrix  Payoff matrix is a table listing the rewards or penalties that each can expect based on the strategy that each pursues  Each prisoner pursues one of two strategies, confessing or clamming up  The numbers in the matrix indicate the prison sentence in years for each based on the corresponding strategies

25 Exhibit 6: Payoff Matrix  Ben’s payoff is in red and Jerry’s in blue.  The incentive for both to confess is the dominant-strategy equilibrium of the game because each player’s strategy does not depend on what the other does.

26 Price Setting Game  The prisoner’s dilemma applies to a broad range of economic phenomena such as pricing policy and advertising strategy  Consider the market for gasoline in a rural community with only two gas stations: a duopoly  Suppose customers are indifferent between the two brands and consider only the price

27 Price Setting Game  Each station sets its daily price early in the morning before knowing the price set by the other  Suppose only two prices are possible: a low price and a high price  If both charge the low price, they split the market and each earns a profit of $500 per day  If both charge the high price, they also split the market and earn $700 profit  If one charges the high price but the other the low one, the low-price station earns a profit of $1,000 and the high-price station earns $200

28 Exhibit 7: Price-Setting Payoff Matrix  What price for each would maximize profits?  Texaco: If Exxon charges the low price, Texaco earns $500 by charging the low price, but only $200 by charging the high price: better off charging the low price.  If Exxon charges the high price, Texaco earns $1,000 by charging the low price and $700 by charging the high price: Texaco earns more by charging the low price.  Exxon faces the same incentives  Each seller will charge the low price, regardless of what the other does: each earns $500 a day.

29 One-Shot versus Repeated Games  The outcome of a game often depends on whether it is a one-shot game or the repeated game  The classic prisoner’s dilemma is a one-shot game: the game is to be played only once  However, if the same players repeat the prisoner’s dilemma, as would likely occur in the price setting game, other possibilities unfold

30 One-Shot versus Repeated Games  In a repeated-game setting, each player has a chance to establish a reputation for cooperation and thereby can encourage the other player to do the same  The cooperative solution makes both players better off than if they fail to cooperate

31 Exhibit 8: Cola War Payoff Matrix  Pepsi’s profit appears in red and Coke’s in blue  Pepsi’s decision: If Coke adopts a big promotional budget, Pepsi earns $2 billion by doing the same, but only $1 billion by adopting a moderate budget: Pepsi should adopt big budget  Coke faces the same incentives  Both will adopt the big budget

32 Tit-for-Tat Strategy  Experiments show that the strategy with the highest payoff in repeated games turns out to be the tit-for-tat strategy  You begin by cooperating in the first round of play  Every round thereafter, you cooperate if your opponent cooperated in the previous round, and  You cheat if your opponent cheated in the previous round

33 Oligopoly and Perfect Competition  Price is usually higher under oligopoly  Profits are higher under oligopoly  If there are barriers to entry into the oligopoly, profits will be higher than under perfect competition, in the long run

34 Comparison of Market Structures